Marginal and Absorption Costing by auu87272

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                Marginal and
                Absorption Costing
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                and Absorption                                                                    1

                The cost per unit of an item is important for
                • setting the selling price
                • valuing stocks
                • calculating profitability.

                Marginal costing

                The cost of an item includes only the variable costs incurred in its production. For example,
                Material components used and piece-rate assembly labour costs.

                Accounting entries

                As costs are incurred (e.g. materials)
                Dr Material Stock Account
                Cr Creditors (or cash) Account
                As materials are issued to production
                Dr Process 1 Account
                Cr Material Stock Account
                Direct labour costs are treated similarly.
                Fixed production overheads are taken straight to the P&L at the year end.

                Absorption costing

                The cost of an item includes the variable costs incurred in its production and a proportion
                of production overheads.
                absorption cost (AC)     marginal cost (MC)     some fixed overhead (FO)

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                 4 Exam Practice Kit: Performance Evaluation

                 The fixed overhead per unit is the absorption rate (FOAR).
                 Possible bases (methods) for sharing out the fixed overheads include
                 •     units
                 •     labour hours
                 •     machine hours
                 •     material usage.

                 Accounting entries

                 All variable production costs are recorded as for marginal costing.
                 In addition, the fixed overhead per unit is transferred to the process account.
                 This gives rise to an under or over absorption of fixed overheads; that is, a balance on the
                 fixed overhead account which is taken to the profit and loss account.

                 Reconciliation: marginal costing and absorption costing

                 Marginal costing profit and absorption costing profit are the same apart from the impact of
                 fixed overheads on stock.
                 They can be reconciled thus
                 Profit per AC                           £x
                 Add: FO in opening stock                £x
                 Less: FO in closing stock               £(x)
                 Profit per MC                           £xx

                 Comparison: MC vs AC

                 MC                                                               AC
                 Good for short-term decision-making               Consistent with external accounting
                 Profit not distorted by stock policy              Prices must cover all costs
                 Treats fixed costs as period costs                Highlights total cost of producing

                 1.1    A company has budgeted production of 500 X’s and 300 Y’s next year. Y’s take twice
                        as long to make as X’s.
                        Total fixed overheads are expected to be £102,000.
                        Costs relating to the X are budgeted at
                        Materials:             3,000 kg           £24,000
                        Labour:                2,000 hours        £40,000
                        Fixed overheads are to be absorbed on an hourly basis.
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                                                                             Marginal and Absorption Costing 5

                      In addition to the above some material normally goes to waste, this is expected to
                      amount to 10% of materials purchased.
                      What is the absorption cost per unit of X?
                      A   £225.52
                      B   £226.05
                      C   £260.30
                      D   £260.83
                                                                                                     (4 marks)

                1.2   A company’s production and sales were budgeted at 300 units.
                      Actual production was 315 but sales were only 295.
                      The marginal cost profit was

                                                     £                 £
                      Sales                                         64,900
                      Materials                  15,750
                      Labour                     15,750
                      Closing stock               2,000
                      Fixed overheads                                9,000
                      Net profit                                    26,400

                      All costs were in line with expectations.
                      There was no opening stock.
                      What would the under/over absorption of overheads have been if the company had
                      used absorption costing?
                      A   £150      Under absorbed
                      B   £150      Over absorbed
                      C   £450      Under absorbed
                      D   £450      Over absorbed
                                                                                                     (2 marks)

                1.3   A company is considering improving its quality system leading to an improved repu-
                      tation and eventually a higher selling price.
                      Its current costs are shown below:

                                                                  Old system           New system
                      Total demand                                3,600 units          3,600 units
                      Defective production                        20%                  10%
                      Labour cost per unit produced               £35                  £43
                      Total material per unit                     3.2 kg               3.5 kg
                      Price per kg of material                    £3.20                £3.95
                      Overheads                                   £18,000              £29,560
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                 6 Exam Practice Kit: Performance Evaluation

                       Which of the following is closest to the increase in selling price needed to justify this
                       A    £3.20
                       B    £9.80
                       C    £11.40
                       D    £15.00
                                                                                                      (4 marks)
                 1.4   A company budgeted to produce and sell equal numbers of units. In fact production
                       was above budget whilst sales were below budget.
                       Which of the following statements about marginal costing and absorption costing
                       profits is most likely to be true?
                       A    absorption costing profits will be higher than marginal costing profits
                       B    absorption costing profits will be equal to marginal costing profits
                       C    absorption costing profits will be lower than marginal costing profits
                       D    absorption costing profits could be higher or lower or equal to marginal costing
                                                                                                    (2 marks)
                 1.5   The following are claimed to be advantages of marginal costing over absorption costing.
                         (i) Marginal costing avoids arbitrary sharing of costs.
                        (ii) Marginal costing is better for short-term decision-making.
                       (iii) Marginal costing avoids profit distortions due to stock fluctuations.
                       Which of these claims are substantially true?
                       A    (i) and (ii) only
                       B    (ii) and (iii) only
                       C    (i) and (iii) only
                       D    all of them
                                                                                                      (2 marks)
                 1.6   The following details have been extracted from the budget papers of LK plc for June
                       Selling price per unit                       £124
                       Variable production costs per unit           £54
                       Fixed production costs per unit              £36
                       Other variable costs per unit                £12
                       Sales volume                                 12,500 units
                       Production volume                            13,250 units
                       Opening stock of finished items              980 units
                       If budgeted profit statements were prepared by using absorption costing and then by
                       using marginal costing,
                       A    marginal costing profits would be higher by £27,000.
                       B    absorption costing profits would be higher by £27,000.
                       C    absorption costing profits would be higher by £35,000.
                       D    absorption costing profits would be higher by £62,000.
                                                                                                      (2 marks)
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                                                                          Marginal and Absorption Costing 7

                1.7   The following are the results of last year’s production.
                      Budgeted overheads £8,000
                      Budgeted production 4,000 units
                      Actual overheads £8,500
                      Actual production 3,800 units

                      What is the over/under absorption?
                      A   £500 under absorption
                      B   £500 over absorption
                      C   £900 under absorption
                      D   £900 over absorption
                                                                                                  (2 marks)

                1.8   A company’s cost card is shown below.

                      Materials                      10
                      Labour                         15
                      Fixed overheads                 8
                      Variable selling costs          7
                      Selling price                  50
                      Profit                         10

                      Last year 4,000 units were produced, of which 3,750 were sold. Actual fixed overheads
                      were £28,000. There was no opening stock.
                      Calculate the profits under marginal costing and absorption costing, and reconcile
                                                                                              (5 marks)

                1.9   In what situations is absorption costing more appropriate than marginal costing?
                      Are there any situations where marginal costing is more appropriate?
                                                                                                  (5 marks)


                1.1   B
                      Note that material cost given represents only 90% of total costs and must be increased
                      by a factor of 10/9.
                      The overheads must be shared between the products using labour hours (2,000     500
                      4 hours for an X and therefore 8 hours for a Y).
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                 8 Exam Practice Kit: Performance Evaluation

                       Material cost: £24,000 10/9 £26,667
                             Per unit (£26,667 500)                                  53.33
                       Labour cost per unit (£40,000 500)                            80.00
                       FO per unit
                             Total hours: X Y
                             500 4 hours 300 8 hours 4,400 hours
                             Overheads per hour: £102,000 4,400 £23.18
                             Per unit of X (£23.18 4 hours)                          92.72
                       AC per unit                                                  226.05   B

                       If you simply added 10% to the material cost then it comes to £52.80 (reducing overall
                       cost to £225.52 A).
                       If you used units to absorb the overheads this gives £127.50 per unit (increasing over-
                       all cost to £260.83 D).
                       Both of these errors give £260.30        C.

                 1.2   D
                       Overheads would be over absorbed since actual production was higher than
                       Remember to use production as a basis for absorption, not sales.
                       Budgeted FO per unit           £9,000   300 units   £30.00

                       Absorbed (£30.00        315)            9,450
                       Spent                                   9,000
                       Over absorbed                             450   D

                       If you use sales to absorb then you would calculate an under absorption of
                       £30.00 295 £9,000 £150 A.

                 1.3   B
                       In the following only the workings for the old system are shown. The new system
                       would be similar.
                       Remember that if sales are to be 3,600 units and 20% of production is defective
                       then only 80% of production is available to be sold. Total production needs to be
                       100/80 3,600 4,500 units.
                       If you calculate defects as 20% 3,600 720 and total production as 3,600 720
                       4,320, then when you lose 20% 4,320 864 there are only 4,320 864 3,456 avail-
                       able for sale.
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                                                                                     Marginal and Absorption Costing 9

                                                                                         Old system       New system
                      Total demand                                                       3,600 units      3,600 units
                      Defective production                                               20%              10%
                      Total production required (3,600            100/80)                4,500 units      4,000 units
                      Labour cost (£35 4,500)                                            £157,500         £172,000
                      Material cost (4,500 3.2 kg             £3.20)                      £46,080          £55,300
                      Overheads                                                           £18,000          £29,560
                      Total costs (157,500 46,080             18,000)                    £221,580         £256,860
                      Cost per unit (221,580       3,600)                                  £61.55           £71.35
                      Increase in cost per unit      £71.35       £61.55        £9.80.

                1.4   A
                      In this case stocks will rise and thus absorption costing will carry forward some
                      overheads to the next period.
                      Thus absorption costing profits will be higher.

                1.5   D
                      All of these are true.
                        (i) Absorption costing has to share fixed costs in an arbitrary manner.
                       (ii) Selling prices need to exceed only variable costs in the short term.
                      (iii) Absorption costing causes profit distortions with stock fluctuations.

                1.6   B
                      Remember that profits will be higher under AC since production sales and so some
                      of this year’s overheads will be carried forward in stock and charged against next
                      year’s income.
                      It is only production overheads that this applies to.
                      Increase in stocks 13,250           12,500 750 units
                      Extra overheads c/f 750             £36 £27,000 B.

                1.7   C
                      Always work out the absorption rate before you start an absorption costing
                      Absorption rate     £8,000/4,000           £2 per unit
                      Total overhead absorbed           £2     3,800 units        £7,600
                      Total amount spent         £8,500
                      Under absorption         £8,500        £7,600     £900.

                1.8   Remember to value stocks correctly: include the fixed overheads only in absorption
                      Marginal cost     £25, absorption cost            £33
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                 10    Exam Practice Kit: Performance Evaluation

                                                 Unit                   MC                         AC
                                                  £             £               £            £             £
                       Sales                     50                          187,500                    187,500
                       Materials                 10           40,000                     40,000
                       Labour                    15           60,000                     60,000
                       FO                        0/8            –                        32,000
                                                             100,000                    132,000
                       Closing stock             25/33        (6,250)                    (8,250)
                                                                              93,750                    123,750
                                                                              93,750                     63,750
                       FO                                                    (28,000)
                       Over absorption                                                                    4,000
                                                                              65,750                     67,750
                       Selling costs             7                           (26,250)                   (26,250)
                       Profit                                                 39,500                     41,500
                       Profit per AC                                         41,500
                       Less: FO in closing stock (£8     250 units)          (2,000)
                       Profit per MC                                         39,500
                 1.9   Absorption costing is more appropriate in the following situations.
                       •   Long-run pricing. In the long run both marginal costs and overheads need to be
                           covered, using absorption costing ensures this will be so.
                       •   Financial accounting. The standardisation of external reporting requirements
                           requires that a reasonable proportion of overheads be included in stock valuations.
                           Many companies want the external and internal accounts to reveal the same level
                           of profits.
                       Where there is only one product the overheads are clearly attributable to that product
                       and the overhead per unit figure is fairly non-controversial.
                       Marginal costing may be more appropriate where stock building is to be discouraged.
                       This is because absorption costing tends to boost reported profits when stocks rise,
                       encouraging managers to stock build.
                       Marginal costing is also more appropriate for short-run pricing decisions since any
                       selling price that covers the marginal costing leads to an increase in contribution and
                       hence profit.

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